Rebalancing Act

Rebalancing ActGlobal diversification gives investors a valuable tool for managing risk and volatility in a portfolio.  But smart diversification has an important side effect. It requires maintenance.

In a given period, asset classes experience divergent performance.  This is inevitable and, in fact, desirable.  However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.”

As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities.  If you let the allocation drift far enough away from your original target, you end up with a different portfolio.

Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity.  This is a strategic priority like portfolio design or investment manager selection.  To efficiently pursue investment goals, we believe you must manage asset drift.

One remedy is to rebalance.  To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value.  The purpose of rebalancing is to move a portfolio back to its original target allocation.  This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-productive.  Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones?  Intuition might suggest that selling previous winners may hinder returns in the future.  This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences.  Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions.  Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility.  Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments.  In the absence of a plan, adjustments are a matter of guesswork.

Challenges and decision factors

In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within these and other categories.  The more complex a portfolio’s allocation, the greater is the need for maintenance2.

Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance.  Rebalancing also incurs transaction fees and potential capital gains in taxable accounts.

Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.

Defining triggering points helps investors decide when to rebalance.  Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations.  This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

While rebalancing costs are unavoidable, certain strategies can help minimize the impact including:

  • Rebalancing with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets.  This reduces transaction costs and the tax consequences of selling assets.
  • Implementing an integrated portfolio strategy.  Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

No one knows where the capital markets will go—and that’s the point.  In an uncertain world, we believe investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.


 

Endnotes

Copyrighted property of Dimensional Fund Advisors, Inc. (“DFA”). Symmetry Partners, LLC has been granted permission to reproduce a portion, or all, of this publication through our agreement with DFA. Symmetry Partners, LLC does not provide tax or legal advice and nothing either stated or implied here should be inferred as providing such advice. The information is provided for educational purposes only and should not be considered investment advice or an offer to buy or sell securities.

Disclosures

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.

Asset allocation and diversification neither assures a profit nor guarantees against loss in a declining market.

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.

Rebalancing assets can have tax consequences. If you sell assets in a taxable account you may have to pay tax on any gain resulting from the sale. Please consult your tax advisor.

Photo Credit: Steve Hardy

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